At the Fed, a Debate Over Countering Inflation Grows Louder

Monday

Aug 25, 2008 at 4:24 AM

Declining oil prices have eased inflationary pressures for the moment, but that hasn’t halted the Federal Reserve’s debate over whether to raise interest rates.

JACKSON HOLE, Wyo. — With the decline in oil prices, inflationary pressures are easing for the moment. The Federal Reserve’s policy makers all acknowledge as much. But that has not halted their debate over whether to raise interest rates now to avoid higher inflation in the future.

The issue moved to a broader forum over the weekend: the Fed’s annual gathering in this mountain resort. The event drew central bankers and economists from abroad, the latter sometimes quite critical of what America’s central bank has done.

“The Fed overreacted to the slowdown in economic activity,” Willem H. Buiter, a professor of European political economy at the London School of Economics and Political Science, declared in his presentation, offering harsh criticism of his hosts. The Fed, he added, “cut the official policy rate too fast and too far and risked its reputation for being serious about inflation.”

Ben S. Bernanke, the chairman of the Federal Reserve, rejects that thinking, as do a majority of the Fed’s policy makers. They argue — and several of them repeated their arguments in interviews here that were mostly off the record — that they had no choice but to cut the key lending rate that the Fed controls to 2 percent from 5.25 percent in just eight months. Otherwise, they said, the housing and credit crises would have resulted in much more damage to the economy.

Now, they argue, the so-called federal funds rate must be kept at 2 percent — for no one knows how long — so that banks and other lenders can borrow at low rates and lend at higher ones, using their fattened earnings from this process to rebuild the capital they need. The banks’ capital eroded as numerous loans made during the bubble years went bad and were written off, reducing their ability and willingness to lend to the public.

“Lenders have been hit by a shock so severe that they are contracting and withdrawing from private sector lending,” Janet L. Yellen, president of the Federal Reserve Bank of San Francisco, said in an interview.

The view expressed by Professor Buiter, however — that a central bank’s overriding concern should be fighting inflation, while a sinking economy is left to be refloated by other means — is welcome thinking for the five or so Fed policy makers, all of them presidents of regional Fed banks, who say that the Fed must begin to raise rates right away.

Mr. Bernanke, in a speech here, said that inflation is likely to moderate as commodity prices come down and the dollar stabilizes. But the Fed bank presidents who want a rate increase now say that he is missing the point. Unless the Fed takes action, they say, people will lose faith in it as a guardian against a rising inflation rate.

When prices do begin to rise, according to their argument, instead of counting on the Fed to stop the process, the American public will ask for and somehow get higher wages to afford the rising prices. Employers will respond by pushing up prices even more — unless the Fed snuffs out this inflationary spiral, or any chance of it, by raising rates, starting now.

“These hawks at the Fed are arguing in effect that we have to throw people out of work more quickly than we already are to ensure against inflation,” said Jan Hatzius, chief domestic economist at Goldman Sachs.

So far, only one of the policy makers is pushing for higher rates. Richard W. Fisher, president of the Federal Reserve Bank of Dallas, has voted for a rate increase at recent Fed policy-making meetings, casting the lone dissenting vote among the Fed’s 11 voting governors and regional bank presidents. The other dissenters have voted with the majority to keep the key federal funds rate at 2 percent, actions that have muted their criticism of this approach.

Now, however, Charles I. Plosser, president of the Federal Reserve Bank of Philadelphia, is likely to join Mr. Fisher. Twice in the past, Mr. Plosser had cast a dissenting vote along with Mr. Fisher, the last time at the April 30 meeting, when the policy makers completed their rate cuts, bringing the federal funds rate to 2 percent. Ever since, he has voted with the majority and in doing so, he has maintained a silence that he says he intends to end soon.

“If we don’t reverse our accommodative stance sooner rather than later,” Mr. Plosser said in an interview here, “we will face rising inflation, which may be costly to deal with, and we will face a risk to the Fed’s credibility to contain inflation.”

In the Fed culture, two dissenting votes at one of its closed-door meetings (the next is Sept. 16) are considered a challenge to the chairman’s authority, raising eyebrows on Wall Street. Three dissents in the past were enough to sink a chairman.

Mr. Plosser argues, however, that Mr. Bernanke, breaking with the practices of past chairmen, encourages differing views, and Mr. Plosser’s dissenting vote, rather than challenging Mr. Bernanke’s authority, would help to communicate the differences that exist among the policy makers.

“Dissent serves a function of illuminating for the public the nature of the policy debates,” Mr. Plosser said.

A big issue in that debate is whether a 2 percent federal funds rate is “accommodative,” as Mr. Plosser put it. Those in his camp argue that it is low enough to encourage people to borrow and spend. Companies would respond to this surge in spending by raising prices, and hence the inflation rate would rise.

The Bernanke camp, in sharp contrast, asserts that 2 percent is anything but accommodative. The nation’s banks and other lenders are indeed borrowing at that rate, to rebuild their capital, but they are lending to consumers at much higher rates — 5 to 6 percent, or more. The large spread signals that the lenders would prefer not to lend at all rather than to risk new loans that, like so many of the old ones, will not be repaid.

The dissenters at the Fed “don’t seem to place much emphasis on the importance of keeping rates low to offset the wide spreads,” said Lawrence H. Meyer, vice chairman of Macroeconomic Advisers and a former Fed governor.

Still, they have the support of Professor Buiter and some other economists — European and American — who argued over the weekend that central banks should concern themselves only with inflation, and not the additional task of maintaining economic growth, as the Fed is required by law to do.

Indeed, while the Fed has cut the federal funds rate drastically over the last year, the European Central Bank has added a quarter of a percentage point to its equivalent of the federal funds rate, suggesting to many that Jean-Claude Trichet, president of the European bank, must be critical of Mr. Bernanke’s failure to embrace an anti-inflation approach.

Mr. Trichet was here over the weekend, and at one of the sessions, he publicly supported the Bernanke approach. Europe, he said, has not yet been hit with “the volume of shocks” to its economy that the United States has suffered, and if he were in Mr. Bernanke’s shoes, he would do as the Fed chairman has done.

“I do not agree that the Fed is too accommodative,” he said.

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